Discussion of Allen, Carletti, Goldstein & Leonello
„Government Guarantees and Financial
Stability“
Gerhard Illing
LMU Munich University/CESifo
Norges Bank Workshop on
Understanding Macroprudential Regulation
29 November, 2012
Central issues
• How to cope with Moral Hazard effects of public interventions
(deposit guarantee schemes)?
• Optimal design of Financial Safety Nets?
• Challenge: Distinguish between fundamental and panic driven runs
(runs due to coordination failure)
• Insolvency vs. illiquidity
• Panic driven runs: Multiple equilibria ~
how to handle indeterminacy?
• Elegant model. Tractable Structure
But only first step – some key issues not yet solved
Summary – Model setup
• Modeling Strategy: Analyze Public Guarantuee Schemes
in Goldstein /Pauzner version of Diamond/Dybvig model
• Model allows for both fundamental and panic driven
bank runs
• Model determines strategies of depositors and banks
endogenously
• Indeterminacy of multiple equilibria solved by
Global Game approach (Goldstein /Pauzner)
• Depositors receive noisy signals about fundamentals
• Inefficiency if runs are panic driven;
Public support improves outcome, but may increase
region with fundamental runs beyond “efficient” level
Summary – Model setup
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Diamond Dybvig type Deposit contract
High return R>1 with p(θ) at date 2
θ: state of the economy
Depositors get noisy signal: xi= θ+εi
θ high: Good fundamentals - no run (upper dominance);
θ≤θ low: bad fundamentals - always run (lower dominance)
intermediate range: multiple equilibria; panic runs
Goldstein/Pauzner Global games solution:
Critical θ*: no run above some threshold θ*!
Both θ and θ* are increasing in c1
In the range θ≤θ≤θ* panic driven runs 
Interventions can prevent panic runs
encourage insurance (higher c1)
Moral Hazard: Support may induce „excessive risk“
- shifting θ(c1) upward beyond some optimal level.
Comments
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Laissez Faire solution:
Banks determine θ*(c1) such that
Marginal gain from better risk sharing
(higher c1 for early consumers) equals
Marginal loss from increased probability of runs (higher θ*(c1) ) c1D
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(Constrained) efficient solution: prevent panic runs 
only fundamental runs;  threshold θ(c1) 
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Problem: How to avoid panic runs?
Costless insurance against panic runs?
Implementation mechanism left unclear in the paper:
Insure depositors only for θ<θ(c1). Resources needed?
Announcement to repay depositors only if θ <θ(c1)
won’t help if private agents cannot observe θ
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c1SP>c1D
General Critique: Clear-cut regions of fundamental and panic runs
implausible ~~ Too simplified view: In reality, signals provide noisy
information about true state of the world  alpha error vs. beta error
Comments
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Social planner allows transfer of resources from some public good
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Idea: Real deposit insurance in period 1:
Guarantee c1SPI>1 in the case of fundamental runs (θ<θ(c1))
Paid out from funds g available for public goods
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Ad hoc modeling strategy
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Since risk averse agents prefer some insurance,
why not insure depositors with c1SPI>1 in all states θ?
Why not also insure against bad realization in period 2?
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Crucial issue:
Resources g modeled as exogenously given; corner solutions
g not properly modeled (deus ex machina): Partial equilibrium!
Determine investment in g endogenously ex ante (distortionary taxes)
Strong incentives to provide insurance pool against systemic risks
Why no private insurance (investment in safe assets; equity funds)?
Comments
Inefficiencies from public guarantee schemes
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Guarantuees induce moral hazard (excessive risk taking):
c1GG >c1SP
θ(c1GG)>θ(c1SP).
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Externality:
Government provides insurance funds without adequate „pricing,“
taking private deposit contracts c1GG as given;
 overinsurance
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In line with intuition, but not worked out properly:
Characterise efficient pricing strategy as benchmark case
~ not done convincingly in the paper (only a first step)
Key argument: Cannot prevent banks to offer contracts c1GG >c1SPI
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Simple mechanism: Provide deposit insurance only for banks
offering contracts with payout c1 ≤ c1SPI
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Other available options : capital adequacy; liquidity requirements
No role in your set-up ~ strong limitation
Comments
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Comparison of different public deposit insurance schemes
All transfer resources from some given public good g to
depositors
1) Pay out c1D to depositors only at t=1
2) Pay out c1D to depositors both at t=1 and t=2
3) Insure all deposit claims fully at t=1 and t=2
Key insight: Optimal scheme depends on size of g
If g is large, full insurance more efficient than moderate
intervention
With tight budget (small g), limited intervention allowing
panic runs is preferred
Limited insight - Puzzle: How to determine optimal size g?
Very preliminary work
Suggestions
• Key problem:
Dynamic inconsistency of conditional guarantee schemes:
Incentives to renege on commitment not to intervene
• Cao/Illing (2011), JICB Endogenous exposure to systemic risk
Banks have incentives to invest excessively in activities prone to
systemic risk
• Allows to model different regulatory designs 
Liquidity (and capital adequacy) requirements can address these
incentives
Diamond/Dybvig framework less suitable –
Sequential Service constraint: Optimality of deposit contracts?
Minor comments:
Analysis incomplete: Compare c1SPI relative to c1SP ?
Upper dominance region: Same return R at date 1 and 2 ~
contradicts initial claims